Why You Don't Want to Cash Out your 401(k) Early

In today's desperate economic climate, many of us are finding ourselves unable to meet our expenses. Raises are frozen. Nobody new is getting hired when people leave. We are being asked to do more work with fewer employees for the same pay, and to stay longer hours to complete the work without any overtime pay. Sometimes the stress is just too much, so you decide to terminate your employment. But how will you pay expenses if you do that?

Let's say you decide you are quitting your job and cashing out your 401(k). While it looks like you might have plenty of money to live on for a while, you really must consider the consequences.

First of all, you are subject to a minimum 10% early withdrawal penalty if you are under age 59 1/2.

Let's say you have $100,000 in your account, including contributions, employer matching funds, and any dividends, interest, or capital gains. Assume also you're 100% vested in your account.

Right off the top, you're only going to get $90,000 of your money, which is treated as a lump sum distribution for income tax purposes. This is treated as taxable income for the tax year you receive the distribution. If you are accustomed to taking a lot of deductions and credits, be warned. This increase in your income will likely disqualify you for many of those deductions and credits.

If this $90,000 is your only income during the tax year in question, you will be in the 25% tax bracket. Expect to pay back $18,817 to Uncle Sam on April 15th. Now you have $71,183 left of your $100,000 401(k).

Next, you may be subject to a state income tax. As of this writing, there are only 9 states that do not have a personal income tax. However, if you live in NJ, you'll owe tax to the state as well. They will take $4,244 of your distribution. Now you have $66,939 of your original $100,000 savings. If you live in a different state, your tax liability may be higher or lower.

You may also live in a locality (town, city, etc.) that charges an income tax. You will need to deduct this amount as well.

If you earned other income during the tax year, you will owe additional taxes and find yourself using some of your $66,939 to pay the tax man.

This is equivalent to losing at least 35% of your retirement savings in one year.

If you decide to take the lump sum distribution anyway, at least have the discipline to set aside HALF of the money you receive to pay any taxes. If you don't, you may find yourself trying to get a loan just to pay the IRS next April!